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While excessive public debt is currently a global problem affecting most of the developed economies, the most dangerous hotspot is the euro zone.

Last month Mario Draghi, the president of the European Central Bank, outlined a new mechanism to address the risks raised by debt issues among a number of member economies. Essentially, Draghi undertook to provide unlimited financial assistance to these problem countries provided they abide by certain conditions.

This conditionality will be designed and monitored by the European Union and the IMF.

Chapter 3 is the distillation of a prodigious research undertaking by the IMF which would have been initiated well before the Outright Monetary Transaction (OMT), as the new vehicle is called, was seen as a solution to the euro zone problem.

Consequently, it is not a formal blueprint. But it will certainly be seen that way as it canvasses both the successes and failures of past policy approaches with considerable candour.

Although it may not appear as being a profound observation, the most important conclusion, with implications not only for the countries directly involved but also reaching as far afield as individual investors, is that reducing public debt takes time, lots of it.

Significantly, given all the criticism we have justifiably seen and heard about the shortcoming of technical analysis by way of econometric modelling, Chapter 3 is classic historical analysis.

It focuses on six case studies spanning almost 100 years, from the United Kingdom in the immediate aftermath of World War I, through the US after World War II, to Belgium, Canada, Italy and Japan in the 1980s and 1990s.

By definition excessive public debt is a product of inappropriate fiscal policies. The study does not confine itself to the fiscal but explores the broader macroeconomic environment encompassing the countries’ monetary stance, financial sector policies and external environment.

Causality is not a concern. The focus is on performance after a certain level of debt (100 per cent of gross domestic product) has been reached.

The first case study, the UK, emerged from World War I with public debt of 140 per cent of GDP. Its policymakers sought to return to the gold standard at pre-war parity in order to restore British trade, prosperity and prestige.

To achieve this outcome the UK government implemented a policy mix of severe austerity and tight monetary policy. As a consequence, real growth in 1928 was below that of 1918.

This was much worse than that of France and even Germany, which had experienced the Weimar hyperinflation. As Keynes remarked, “assuredly it does not pay to be good".

The US experience after World War II was much superior, thanks to policies that are now unlikely to be repeatable. The US emerged with a 120 per cent ratio.

The US succeeded in reducing its public debt by a combination of inflation and financial repression.

There were a couple of substantial bursts of inflation. The first came with the removal of price controls; the second accompanied the Korean War.

In terms of managing public debt, the preservation of price controls in the financial sector, such as a floor under bond prices and ceilings on bank deposit rates, kept nominal interest rates low.

Such a policy mix would involve high institutional (Federal Reserve), political (Congress) and administrative (globalisation) hurdles if even contemplated today.

More to the point, the IMF study points to successful debt reduction programs in Italy (surprising), Belgium and Canada. These countries employed a mix of supportive monetary policies (meaning low interest rates and, presumably, quantitative easing) and large fiscal adjustments where the goal of reaching or maintaining low inflation was seen as paramount.

To be effective the fiscal adjustment needs to be permanent or structural and not just a collection of temporary measures.

In the case of Belgium and Canada, their success in reducing public debt was helped by a favourable export environment and, I suspect, their modest size meant only marginal disruption to trade patterns.

Even when the stars are aligned, debt deleveraging at government level is a slow process. Sustained improvements of more than 1 percentage point a year have been rare.

This means that a country starting from a primary deficit (a deficit which excludes interest payments) takes a particularly long time.

It also means that vulnerability to external shocks is increased. As we have seen, Belgium, Canada and Italy have experienced increased foreign public debt since the global financial crisis began.

For an Australia with a modest and easily manageable level of public debt these issues may appear academic. Far from it.

As
Glenn Stevens
said when announcing the recent cut in Australia’s cash rate, the Reserve Bank board had been influenced by international developments.

Although he didn’t spell it out, there has been growing concern at the impact of foreign inflow on our exchange rate and the way in which this has overridden the traditional effect of declining terms of trade.

The foreign inflow has been attracted by the combination of Australia’s AAA credit rating and the positive differential of Australian interest rates compared with those on offer overseas.

Ben Bernanke
has indicated that monetary policy will remain easy in the United States until 2015.

With the IMF about to take a much greater role in euro zone monetary policy, it is apparent that it too favours an easy and extended monetary stance for countries with high public debt issues.

The message is that the search for yield may well intensify. Certainly it is not going to go away soon.

That’s not a happy story for Australian savers and investors.

So long as global inflation remains quiescent, Australian interest rates are destined to go lower . . . and they will stay lower for longer.